5/02/2011 @ 10:35AM6,012 views

After Bin Laden, What Next For The Defense Industry?

Even before Osama bin Laden was killed by U.S. special forces, storm warnings were up for America’s biggest military contractors. Defense spending has begun declining after ten straight years of increases. Four of the military’s top dozen weapons programs have been canceled since President Obama took office. Pentagon acquisition chief Ashton Carter says more cancellations are coming. The government is tightening up contract terms and conditions, converting from “cost-plus” arrangements to fixed-price vehicles that place greater risk on suppliers.

Not surprisingly, defense equities are trailing the performance of the S&P 500. In fact, the combined market capitalization of the top five military contractors is less than Microsoft‘s, even though they generate three times more revenue. Clearly, investors are signaling doubts about the future of the defense sector. They know that defense equities are a great hedge against downturns in the commercial business cycle, but right now the economy is expanding, and past experience suggests that once military spending heads down, it tends to stay on that vector for a long time. In fact, the last time there was a big decline in defense spending, two-thirds of the top military contractors exited the business.

Nobody is expecting that to happen this time, because so far the Obama Administration’s proposed cuts to the defense budget are relatively modest. But the days of robust defense increases and big new program starts are over, so the only way contractors will be able to generate sizable gains in the military space going forward will be either by increasing overseas sales or stealing domestic market share from competitors. Unfortunately, civil unrest in the Middle East is reducing foreign sales prospects, and with few new starts there won’t be much opportunity to displace incumbents from big domestic franchises.

The defense industry has a standard playbook for how to cope with these downturns that it learned in the busts that followed the Vietnam War and the collapse of communism. Furlough workers. Cut unnecessary investments. Divest under-performing businesses. The big military contractors are already doing those things. But eventually all the easy steps will be exhausted and the generous contracts won in better times will be worked off. Then the sector will have to confront the stark reality that it is dependent on a single customer — the federal government — that has become more concerned about budget deficits than the global war on terror. How do you sell that story to investors who think Apple and BMW look like better bets?

It is usually at this point in a defense downturn that some bright pundit or academic — you know, a person who isn’t really in the business — mentions the “D word,” meaning diversification. Why should an industry sitting on so much cash remain dependent on the whims of a single customer whose interest is clearly flagging when it possesses so many skills relevant to the commercial marketplace? Isn’t now the time to start putting that cash to work outside the defense sector?

Even raising this possibility is considered bad form in the defense business, because past efforts at diversification are thought to have been, in the oft-quoted phrase of former Lockheed Martin CEO Norm Augustine, “unblemished by success.” The prevailing wisdom among industry insiders and investors is that the military marketplace is so unique, so idiosyncratic it cannot spawn commercial success stories. Management and marketing skills are not transferable, the thinking goes, since the federal customer is a political animal that seldom behaves like an economic rational actor.

Beyond this cultural argument, there is concern about the reaction of the investment community. Military contractors who diversify undercut the “counter-cyclical” character of their stocks that is said to be a key attraction for institutional investors. In other words, defense equities cease to be a useful hedge against downturns in the commercial business cycle if they are over-exposed to it. Also, many analysts favor pure-play stocks that focus on a single sector or product area, arguing that conglomerates impede the ability of investors to target their market bets precisely. And then there is the simple inconvenience of having to analyze a “multi-industry” company with a diverse customer base. Other things being equal, investors prefer a simple story.

It was the latter two concerns that led ITT to decide recently it should spin off its defense operations in response to investor pressure. The New York-based conglomerate argued that by separating into three focused enterprises, it could “free up” the underlying potential of each product line. Bankers are pressing other multi-industry companies with big defense holdings like Textron to make a similar move, although the Providence-based conglomerate shows little evidence of being interested. Textron executives like the resilience and flexibility they get from being a major player in diverse markets; the company’s steady income from military programs was a stabilizing factor when its finance arm got caught up in the sub-prime credit meltdown three years ago.

Time will tell whether ITT’s pure-play strategy or Textron’s multi-industry approach works out better, but if the coming defense downturn proves to be protracted, then every big military contractor in America will eventually have to engage in similar deliberations. Since none of the top companies — Lockheed Martin, Boeing, Northrop Grumman, General Dynamics, Raytheon — is likely to abandon defense, any discussion of diversification is also about the advisability of becoming a conglomerate. In that regard, it is worth noting that all of the biggest players in the sector are already conglomerates in some sense of the term.

Industry leader Lockheed Martin has expanded beyond defense into many other parts of the federal marketplace, mainly through its sprawling information services unit. Boeing’s business mix is divided almost evenly between defense and the commercial transport sector. General Dynamics is counting on its Gulfstream business jets to compensate for any downturn in military demand, and its networking unit counts customers as far afield from the Pentagon as T.J. Maxx parent TJX. Even Massachusetts-based Raytheon, a one-time conglomerate that has gradually divested commercial lines over the last two decades, has non-defense franchises in areas like air-traffic management and civil communications.

So the real question for defense executives isn’t whether they want to do something other than supply the military, but rather how far afield they are willing to wander as Pentagon demand softens. In the absence of some major new threat that stimulates defense demand, there are at least as many “push” factors — negatives within the defense sector — encouraging them to become more adventurous as there are pull factors in the commercial arena. First, there is the government customer’s push to tighten up terms on contractors whose returns are already only about average compared with other sectors. Second, there is the fact that too many players are crowding into the handful of growth opportunities in defense such as cyber-security for anyone to make a killing. Third, there is the way in which military demand is converging with commercial demand in terms of what new technologies are most valued. Fourth, there are the very high valuations that sellers are demanding for well-positioned properties in the defense sector, making a strategy of growing through acquisitions unattractive. And finally, there are the repeated warnings policymakers have made to the biggest contractors that mergers between first-tier firms will not be approved.

Conditions in the defense sector thus discourage the kind of consolidation moves that enabled contractors to weather past downturns. In fact, most of the recent strategic activity among top-tier contractors involves getting rid of military units that were under-performing or conflicted, rather than buying deeper into the business. Conditions also aren’t all that favorable for expanding into non-defense adjacencies in the federal marketplace, because domestic discretionary spending is the area of the budget being targeted most intensively by deficit cutters. So if you are a company like Lockheed Martin that has to generate over $100 million in new sales every day of the year just to stay at your present size, the point is fast approaching when commercial options will have to be entertained. Nothing elsewhere in the federal space can rescue you from a big downturn in defense, and business conditions at the state and local level are at a low ebb.

Diversification strategies have been out of favor for so long in the defense sector that there aren’t many real-life models for how executives should proceed. The most successful multi-industry player in defense is probably United Technologies, which has managed to reconcile being a market leader in commercial businesses like elevators and air conditioning with being the military’s top supplier of helicopters and jet engines. But some observers would say that focusing too heavily on military customers is one reason why UTX’s Pratt & Whitney propulsion unit lost its way in commercial engines, a problem it is now seeking to rectify through introduction of the revolutionary geared turbofan.

A more suitable model for contractors that want to remain mainly in the military space might be General Dynamics, a company that ignored the conventional wisdom to successfully diversify into business jets a dozen years ago. GD has managed to build Gulfstream’s global brand as a high-end provider of executive transport even as it steadily expanded its military business over the past decade — greatly outperforming both its defense industry peers and the S&P 500. The key to GD’s success, other than some very exceptional leadership, seems to have been a decentralized management system in which business units were given the freedom to operate as they wished in their core markets as long as they satisfied demanding financial metrics.

Said differently, General Dynamics is run by the numbers as a portfolio of loosely connected businesses, rather than as a tightly integrated enterprise. In a sector where engineers tend to dominate and functional synergies are highly valued, the GD model is unusual. But it is a model well-suited to defense companies that might be contemplating diversification. For example, Lockheed Martin’s headquarters in the Maryland suburbs of the nation’s capital is surrounded by one of the world’s largest life-sciences complexes. Life sciences is expected to be a growth area for new drugs and technologies — one in which America leads the world — and yet Lockheed plays no role in that market. A numbers-driven, portfolio-type strategy to pursue new business opportunities could enable Lockheed Martin to tap into life-science growth opportunities without impairing its core defense business.

Cultural or technological synergies might follow later — much of life-sciences research is traceable to federal funding sources and utilizes information technologies in which the company is well versed — but in the near term any such move would be mainly about deploying capital productively. The main options management has right now are to reinvest its funds into a flat defense sector or return the money to shareholders through stock repurchases and the like. Those are time-honored strategies, but they probably can’t compete with participating in a global life-sciences revolution in terms of investor appeal. Of course there would be pushback from investors at first, just the way there was when General Dynamics bought Gulfstream, but Lockheed wouldn’t be betting the farm and in the end what Wall Street cares about is earnings.

It isn’t hard to imagine similar scenarios for other defense companies. The cultural arguments for avoiding diversification militate against getting into totally alien markets like retailing or real estate, but how much difference is there really between building planes and ships for the government and building them for a big company like Maersk? It’s all basically capital equipment, and the defense sector has generated many products in the past that proved to have huge commercial potential, from lasers to microchips to satellites to the internet. It may need some help from outsiders with marketing and product placement, but diversification probably makes more sense than just sticking with a capricious federal customer as the walls close in. And with Osama bin Laden now gone, that contraction could unfold faster than expected.

Loren Thompson is Chief Operating Officer of the non-profit Lexington Institute and Chief Executive Officer of the private consultancy Source Associates. The Lexington Institute receives money from many of the nation’s leading defense contractors, and Source Associates provides technical services to companies in the industry.

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As in all Departments, meaningful budget cuts will still have to be made at Defense, more now than prior to the death of OBL. The fundamentals of the fiscal problem still exist with or without the spectre of OBL.

With a looming $100 trillion unfunded entitlement program debt, the Federal government has no choice…unless they wish to face default as shown here:

It is interesting that the death of OBL should be seen as an end to the US war on terror. Certainly the terrorists are no hinting that this will be the case. Their figurehead is dead, but is now a martyr in the eyes of terrorists. I have read that the USA has called back its biological and radiological experts back from Japan on this news of OBL being bagged. I read that we are a new heightened alert, and yet you all quack around about the end of military spending. Here we find out that Pakistan was certainly hiding OBL (no question now)But suddenly the world has gotten safer? You folks are funny.